Unused 529 Plans

What to Do When Plans for Paying for College Change

Unused 529 Plans
February 16, 2016

529 plans are an excellent method to save for a college education. They are state-operated investment accounts that allow anyone to contribute after-tax dollars toward your child's education. Earnings build up tax free, and remain so if they are used for qualified educational purposes.

However, if funds are withdrawn for non-educational purposes, the earnings portion will be subject to taxes, and penalties generally apply. The penalty is 10% of the withdrawn funds, and the tax rate will be at the normal tax rate for the withdrawing individual (generally the person who established the fund).

If you claimed 529 contributions as deductions on your state taxes, you will have to pay back taxes covering all those deductions if the funds are withdrawn for non-qualified purposes.

Penalties are waived in several circumstances:

  • Death/Disability – If the beneficiary dies or suffers a disabling injury, the penalty is waived.
  • Scholarship – When a scholarship is awarded, a portion of the 529 plan that is equal to the amount of the scholarship can be withdrawn without penalty.
  • Military – If the beneficiary decides to attend a military academy, rules similar to the scholarship exemption apply.

There are other partial exemptions, such as employer-provided or veteran's educational assistance that may apply.

Let's assume that none of these exemptions apply, and you have leftover funds because your son or daughter has decided to bypass college and get a job, backpack through Europe to "find themselves", or something in-between. What are your options for the funds?

  • Change Beneficiary – You can change the beneficiary to anyone in a reasonably long list of family members, including close step-relatives, in-laws, and first cousins. In many cases, it can be carried over to grandchildren, although there may be potential gift taxes involved and some state 529 plans impose time limits. You can even use it for your own qualified educational purposes. If you are laid off and need to take educational retraining courses at qualified institutions, or want to enhance your current education, you are free to do so.
  • Cash Out – You can simply close the account and take your hit. Depending on the 529 plan, you may be able to direct the withdrawals toward the beneficiary, who is presumably in a lower tax bracket. If you are close to retirement age, you may be able to wait it out and cash in the account when you are in a lower tax bracket – although this skirts the basic intent of the law, and states may impose further penalties. The plan could even be terminated if there is reason to think it is being used only as a shadow retirement plan.

  • Do Nothing – Should your son or daughter decide that the real world is preferable to college, after spending a few years immersed in it he or she may have a change of heart. Similarly, there's nothing like running out of money to help young adults truly "find themselves". In which case, they may decide to use the 529 after all. Consider this possibility before changing beneficiaries, unless you have another relative in immediate need. Again, you need to check your individual 529 plan for time limits and other restrictions.

Having leftover money in a 529 is a good problem to have – how many times in your life is leftover money in your account going to be a problem for you? Not many, we suspect. Try to use it for the educational benefit of someone in your family, but if you cannot do so, don't feel bad if you have to cash out.

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